Tier 1 Leverage Ratio
What Is the Tier 1 Leverage Ratio?
The Tier 1 leverage ratio measures a bank's core capital relative to its total assets. The ratio takes a gander at Tier 1 capital to judge how leveraged a bank is based on its assets. Tier 1 capital are those assets that can be effectively liquidated in the event that a bank needs capital in the event of a financial crisis. The Tier 1 leverage ratio is subsequently a measure of a bank's close term financial health.
The Tier 1 leverage ratio is regularly utilized by regulators to guarantee the capital adequacy of banks and to place imperatives on the degree to which a financial company can leverage its capital base.
The Formula for the Tier 1 Leverage Ratio Is:
Instructions to Calculate Tier 1 Leverage Ratio
- Tier 1 capital for the bank is placed in the numerator of the leverage ratio. Tier 1 capital addresses a bank's common equity, retained earnings, reserves, and certain instruments with discretionary dividends and no maturity.
- The bank's total consolidated assets for the period is placed in the denominator of the formula, which is normally reported on a bank's quarterly or annual earnings report.
- Partition the bank's Tier 1 capital by total consolidated assets to show up at the Tier 1 leverage ratio. Increase the outcome by 100 to change the number over completely to a percentage.
What Does the Tier 1 Leverage Ratio Tell You?
The Tier 1 leverage ratio was presented by the Basel III agrees, an international regulatory banking treaty proposed by the Basel Committee on Banking Supervision in 2009. The ratio utilizes Tier 1 capital to assess how leveraged a bank is comparable to its overall assets. The higher the Tier 1 leverage ratio is, the higher the probability that the bank could endure a negative shock to its balance sheet.
Parts of the Tier 1 Leverage Ratio
Tier 1 capital is the core capital of a bank as indicated by Basel III and comprises of the most stable and liquid capital as well as the best at engrossing losses during a financial crisis or downturn.
The denominator in the Tier 1 leverage ratio is a bank's total exposures, which incorporate its consolidated assets, derivative exposure, and certain off-balance sheet exposures. Basel III required banks to incorporate off-balance-sheet exposures, for example, commitments to give loans to outsiders, standby letters of credit (SLOC), acknowledgments, and trade letters of credit.
Tier 1 Leverage Ratio Requirements
Basel III laid out a 3% least requirement for the Tier 1 leverage ratio, while it left open the possibility of expanding that threshold for certain deliberately important financial institutions.
In 2014, the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) delivered regulatory capital rules that forced higher leverage ratios for banks of certain sizes effective as of Jan. 1, 2018. Bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under management must keep an extra 2% buffer, making their base Tier 1 leverage ratios 5%.
Furthermore, in the event that an insured depository institution is being covered by a corrective action structure, meaning it exhibited capital lacks in the past, it must show basically a 6% Tier 1 leverage ratio to be viewed as very much capitalized.
Genuine Example of the Tier 1 Leverage Ratio
The following are the capital ratios taken from the financial statements of Bank of America Corporation (BAC) as reported in the bank's Q3 earnings report on October 31, 2018.
Featured in yellow at the lower part of the table, a Tier 1 leverage ratio of 8.3% for the period was reported by the bank.
We can compute the ratio by taking the total Tier 1 capital of $186,189 billion (featured in green) and gap it by the bank's total assets of $2.240 trillion (featured in blue).
The calculation is as per the following:
Bank of America's Tier 1 leverage ratio of 8.3% was well over the requirement of 5% by regulators.
The Difference Between the Tier 1 Leverage Ratio and the Tier 1 Capital Ratio
The Tier 1 capital ratio is the ratio of a bank's core Tier 1 capital — that is, its equity capital and unveiled reserves — to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation.
The Tier 1 capital ratio measures a bank's core equity capital against its total risk-weighted assets, which incorporate every one of the assets the bank holds that are methodicallly weighted for credit risk. The Tier 1 leverage ratio measures a bank's core capital to its total assets. The ratio utilizes Tier 1 capital to judge how leveraged a bank is corresponding to its consolidated assets, while the Tier 1 capital ratio measures the bank's core capital against its risk-weighted assets.
Limitations of Using the Tier 1 Leverage Ratio
A limitation of utilizing the Tier 1 leverage ratio is that investors are dependent on banks to appropriately and sincerely compute and report their Tier 1 capital and total assets figures. In the event that a bank doesn't report or work out their figures appropriately, the leverage ratio could be off base. A leverage ratio above 5% is at present the thing regulators are searching for, however we will not really know until the next financial crisis hits to see if banks are genuinely able to endure a financial shock that it causes.
Features
- The Tier 1 ratio is employed by bank regulators to guarantee that banks have sufficient liquidity close by to meet certain essential stress tests.
- A ratio above 5% is considered to be an indicator of strong financial balance for a bank.
- The Tier 1 leverage ratio compares a bank's Tier 1 capital to its total assets to assess how leveraged a bank is.
